Financing Smallholder Climate-Smart Agriculture Adoption by Rishi Basak. Working Paper, 2017

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1 TECHNICAL SUMMARY Financing Smallholder Climate-Smart Agriculture Adoption by Rishi Basak. Working Paper, 2017 Agrifin Technical Summaries aim to make technical studies and reports on agriculture finance more accessible to practitioners, especially bankers and other professionals supporting the agriculture ﬁnance industry. The findings, interpretations, and conclusions expressed in the summarized publications do not necessarily reﬂect the views of Agrifin, neither does Agrifin guarantee the accuracy of the data included in the summarized publications.

2 INTRODUCTION Climate-Smart Agriculture requires a different finance model to traditional smallholder farm lending. This study examines how attractive this type of investment can be to commercial banks, showcases successful initiatives from around the world and identifies ways to unlock new sources of private sector capital - encouraging more widespread adoption of CSA practices and technologies. WHAT IS CLIMATE-SMART AGRICULTURE AND WHY IS ITS FINANCING DIFFERENT? Agriculture plays a significant role in the economies of most developing countries, providing direct and indirect employment to the rural and urban labor force alike. The sector faces major climate related challenges that look set to intensify in the near future. According to the Food and Agriculture Organization of the United Nations (FAO), long-term changes in temperature and precipitation patterns, (part of climate change) are expected to shift production seasons, alter pest and disease patterns, and modify the range of feasible crops - affecting production, prices, incomes, and ultimately livelihoods and lives. Agriculture is also a significant user of natural resources and can negatively impact the environment if it isn t practiced sustainably. Climate-Smart Agriculture (CSA) aims to: increase productivity, make farming more resilient in the face of climate change and reduce greenhouse gas emissions from agricultural practices; achievable by adopting CSA technologies and practices ranging from more efficient input use, to using improved crop varieties and specialized machinery. Traditionally, credit needs of farmers center around obtaining working capital in the form of a seasonal loan to procure planting materials, inputs (chemicals and fertilizers), as well as paying for extra labor at critical times - harvest for example. Farmers who wish to purchase equipment may seek out additional longer-term loans Financing requirements for Climate-Smart Agriculture differ somewhat, incorporating: 1. Seasonal working capital loans (for seeds, inputs and labor) 2. Long-term loans for climate-smart equipment (e.g. zero-tillage drill) 3. Loans with longer maturities to accommodate the initial productivity loss that can accompany adoption of certain CSA practices 4. Longer grace periods - especially where initial productivity losses are felt for multiple seasons And unlike traditional farming, smallholders adopting CSA are utilizing agricultural practices that: Have been carefully studied Have demonstrable productivity increases And lead to reduced crop losses due to climate impacts - reducing lenders risk. However, advancement of Climate-Smart Agriculture is hampered by a lack of adequate finance to cover up-front investment (purchasing

optical sensors or zero tillage drills for example) as well as working capital (when the practice initially reduces yield); a funding shortfall caused by low productivity in traditional smallholder

3 optical sensors or zero tillage drills for example) as well as working capital (when the practice initially reduces yield); a funding shortfall caused by low productivity in traditional smallholder farming along with ever-higher climate change risk that deters private investment. If appropriate sources of capital can be unlocked, CSA practices and technologies offer an opportunity to increase productivity, while making farming more resilient and reducing greenhouse gas emissions - farmers who adopt CSE are in a better position to pay back their loans. And CSA produces a public good as a co-benefit - reducing negative social repercussions associated with low resilience, which, in turn, can attract impact investors. Source: Falconer et al. (2016) WHO IS SUCCESSFULLY FINANCING CSA? Despite a lack of private sector finance, there are still many examples of successful implementation of Climate-Smart Agriculture in developing countries. Cost benefit analyses show how CSA practices increase productivity and farmer resilience, while reducing greenhouse gas intensity. The figure below shows how farmers who adopt CSA practices are significantly more profitable under adverse weather conditions, compared to those using traditional farming methods, putting them in a better position to repay loans. The figure below shows how farmers who adopt CSA practices are significantly more profitable under adverse weather conditions, compared to those using traditional farming methods, putting them in a better position to repay loans. Some commercial banks have already experimented with CSA financing, including global players such as Crédit Suisse and Deutsche Bank, as well as regional development banks and local financial institutions. Crédit Suisse has shown interest in conservation finance - a broad-ranging approach to encourage farming practices that incur environmental benefits. Conservation finance provides cash flow to farmers and land managers via direct or indirect investments. A portion of the returns from production are used for conservation purposes, while the balance is used to pay back the loan Working with the McKinsey Center for Business and Environment, Credit Suisse has analyzed the potential of conservation finance, finding that the main financial vehicles are debt and equity funds, as well as the proceeds of bonds and notes. They advocate that as the assets involved (natural

4 capital, such as agricultural land or forests) are independent from macroeconomic developments and uncorrelated to equity markets, conservation finance is an attractive investment to diversify an investment portfolio; estimating that total capital expected to be invested in conservation finance by 2020 is between $200 and $400 billion USD. Deutsche Bank has a range of investment funds and loans to support growth and innovation in agriculture, enabling customers to invest throughout the entire value chain, via special funds such as the Africa Agriculture and Trade Investment Fund (AATIF). AATIF is a public-private partnership providing farmers and agri-businesses with capital, either directly or through the local banking system. Similarly, their loans provide credit to agricultural value chain participants from farmers to trading companies. DB has a long history of working with development finance institutions, such as the German KfW (Kreditanstalt für Wiederaufbau, Reconstruction Credit Institute ), who provide first loss capital via grants or loan guarantees, helping de-risk environmental and climate-focused projects and attract private capital via debt or equity. The European Investment Bank (EIB) offers financial services across the agri-food and fishery value chain to: Foster increased productivity Improve and restore ecosystems And encourage the adoption of innovative agricultural solutions. Partnering with the International Fund for Agricultural Development (IFAD), EIB focuses on agricultural investments that encourage sustainable and inclusive growth. Joint projects are in the pipeline, with EIB offering financial instruments, such as loans and guarantees, to better suit the needs of smallholder farmers. The EIB also supports high impact microfinance initiatives, such as the European Solidarity Financing Fund for Africa (Fefisol) and the Participatory Microfinance Group for Africa (Pamiga). Fefisol is a microfinance fund focused on rural clients, fair trade and organic production Pamiga is a network of rural microfinance institutions promoting access to reliable and clean energy, as well as efficient irrigation for smallholder farmers. The EIB s EUR 4 million loan to Pamiga will be lent on to microfinance institutions in Benin, Burkina Faso, Cameroon, Kenya, Madagascar, Senegal, Tanzania and Togo. These microfinance institutions in turn offer loans to farmers for the purchase of equipment, such as solar kits and irrigation systems. The Inter-American Development Bank (IDB) and the Nordic Development Fund, working with the Global Environment Facility, have setup the Climate-Smart Agriculture Fund for the Americas and the Caribbean. This US$16.5 million initiative aims to attract investment in sustainable agriculture, forestry and rangelands via private equity, debt from IDB and commercial banks, or a combination of the three. The fund s concessional financing extends maturities and cushions initial losses - attractive to private sector investors - and direct clients are agribusinesses involved in climatesmart agriculture in the region. KfW Bankengruppe, AgDevCo and Root Capital

5 have invested in LAFCo, a Mauritian investment company providing loans to African agribusinesses that work directly with smallholder farmers (e.g. input providers, processors, traders, exporters and warehouses). LAFCo s aim is to benefit the agricultural sector by helping businesses and smallholder farmers increase productivity and generate more income, as well create more reliable markets. It provides working capital financing (shortterm loans and flexible lines of credit) to value chain participants with gross assets of less than US$15 million and fewer than 300 employees. OPPORTUNITIES FOR COMMERCIAL BANKS AND OTHER FINANCIAL INSTITUTIONS Opportunities for commercial banks and other financial institutions Various financial instruments could be used to bridge the funding gap in smallholder agriculture, including: Direct commercial lending Warehouse financing And microfinance. The Housing Development Finance Corporation (HDCF), an Indian banking and financial services company, undertakes correspondent banking via agricultural value chain participants who act as loan providers, reducing transaction costs and spreading risk. The loans finance the supply of agricultural inputs, such as seeds, fertilizers, pesticides and irrigation equipment. Although CSA practices can increase productivity, they often induce production lag - it can be three to five years before positive returns are achieved. Short-term losses are especially acute where ecosystems require restoration. So, any medium to long-term financing must allow smallholder farmers to make the investment required to adopt the CSA approach, even though returns may only be realized several years down the line. The FAO has funded a project in the Tibetan Highlands to restore rangelands. Financing includes compensation to smallholder farmers for the temporary loss of income associated with the reduction of their herd size and/or taking land out of production to achieve longer term goals. Realistic options that commercial banks and financial institutions can offer to help smallholder farmers adopt CSA technologies and approaches include: Offering climate-smart loans for fixed assets and/or working capital to groups of smallholder farmers: cooperatives, farmer producer groups, or farmers supplying the same processor, which lowers transaction costs. Loans would need to create the incentive for farmers to continue to use CSA techniques and to attract new adopters. Such initiatives have already been implemented by commercial banks in many developing countries. Value chains participants in developing countries are often dispersed - limiting opportunities to work with aggregators. Digital financial services are increasingly used as a workaround to make microfinance available. In Madagascar, Airtel (a mobile network operator) has partnered with the Bank of Africa to offer small loans to farmers for equipment purchases, storage costs and to provide essential cash flow between growing seasons. Working with a local NGO, they re helping cashew, vanilla and red rice producers

6 conserve biodiversity, improve marketing process, and use mobile banking for receipt of payments for the sale of the goods they produce. Bancamía, a Colombian commercial bank, is also targeting key agriculture value chains with mobile lending, sensing an opportunity to reduce agricultural lending costs. Points of aggregation in the value chain open up other types of lending - providing finance to warehouses, procurement networks and input providers can lower marketing and operating costs, compared to trying to reach dispersed smallholder farmers directly. Warehouse receipt systems allow producers to store a stated quantity of a given commodity, obtaining a receipt that can be used as collateral for a bank loan. The loan provides cash flow and storage allows sale when prices are higher. Transaction costs are reduced, because farmers can then sell their crop electronically or via paper. In Tanzania, thanks to support from Rabobank, the National Microfinance Bank is lending to 300,000 smallholder farmers through 500 aggregators via warehouse receipt financing. With upwards of US$15 million in financing, non-performing loans stood at less than 6%. Similarly, KfW Bankengruppe is partnering with the Ministry of Agriculture and Food Security to develop a large warehouse receipt financing scheme in Burkina Faso. Value chain finance is any or all of the financial services, products and support services flowing to and/or through a value chain to address the needs and constraints of those involved in that chain, be it a need to access finance, secure sales, procure products, reduce risk and/ or improve efficiency within the chain (Miller and Jones 2010, p.2). In Myanmar input suppliers offer smallholder farmers the opportunity to defer payment on fertilizer. In Kenya fruit and vegetable growers can use their export contracts to secure financing for the purchase of agrochemical spray services. The Kenyan scheme, a partnership between a commercial bank, the USAID Kenya Business Development Services Program and other private sector organizations, reduces transaction costs, as the exporter pays farmers through the bank, which in turn deducts the amount from the loan payments. Similarly, the agrochemical spray providers consolidate their receipts and are paid by the bank. Financing via aggregators offers another way to reach dispersed participants. Aggregators can mitigate risks by pooling the resources of many farmers (producing a wide range of agricultural commodities). This allows them to obtain credit from financial institutions at better rates and onlend to farmers. Aggregator financing is a well-established approach to reach smallholder farmers. On a larger scale, the International Finance Corporation, NIB Bank, and nonprofit TechnoServe, setup a risk sharing facility to assist coffee farmer cooperatives in Ethiopia. The credit enables cooperatives to purchase processing equipment and meet their working capital needs. Each participating cooperative receives between $100,000 and $200,000, depending on their production target for the season. The project hopes to reach over 50,000 coffee farmers and disseminate the financing model to other crops. To increase financing of CSA adoption, commercial banks must aim to:

7 Reduce transaction costs for farmers Mitigate short-term losses Incentivize continued use of CSA practice Implement digital finance initiatives to reach dispersed value chain participants Use points of aggregation in the value chain to open up new types of lending Note holders have first access to any income generated (based on the performance of the investments made by the funds), followed by holders of junior, mezzanine and senior shares. Note holders only receive a fixed interest rate, but are protected against losses due to the notes senior ranking against other risk-bearing tranches. CASE STUDY - FINANCE IN MOTION Finance in Motion (FiM) manages impact funds and advises funds with around EUR 1.6 billion in assets under management. Investors include: The German Federal Ministry for Economic Cooperation and Development (BMZ) The International Finance Corporation (IFC) The European Bank for Reconstruction and Development (EBRD) And the European Investment Bank (EIB). FiM s goal is to achieve triple bottom line impacts economic, social and environmental for public and private investors, by developing, managing and advising open-end alternative funds (with shares that vary in price in proportion to the fund s net asset value variability). Funds are setup as public- private partnerships, with investors allocating money into various riskbearing tranches. Public investors offer seed money via grants that help de-risk through first-loss junior shares, whereas development banks are issued senior or mezzanine shares, and private investors invest in notes. Holders of senior shares only face a net loss in the event junior and mezzanine shares get depleted, followed by notes. Holders of junior, mezzanine and senior shares are entitled to complementary dividends, in addition to the target dividend. Public sector bodies who have invested in junior shares expect clearly agreedupon and measurable impacts. Mezzanine shares, held by international financial institutions (IFIs) such as IFC, EBRD and EIB, have maturities between seven and ten years. They bring a higher return than junior shares and offer a strong voting representation. Senior shares on the other hand, which are also held by IFIs, offer slightly lower returns and have shorter maturities (usually between three and ten years). Fixed payment obligations are set out over a period of three to five years via notes that are placed with the private investors. Note holders will usually receive a fixed interest rate that is above a negotiated benchmark, such as the Euro Interbank Offered Rate, or the US Dollar London Interbank Offered Rate. Over time, as impact funds grow, the investment risk is reduced and operating expenses are spread over a larger asset base, attracting additional note investors. This, in turn, increases the leverage ratio of public sector holders of junior shares. Sources: Finance in Motion (2014a, 2014b)

EIB s financing mechanisms in agriculture in Africa

EIB s financing mechanisms in agriculture in Africa Brussels Policy Briefing n 39 Global food systems, local impact: the role of agribusiness and development partnerships in advancing African agriculture